Overview of Distressed Debt Investing 8-31-10

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Distressed Debt Investing – An Overview

“Buy to the sound of cannons and sell to the sound of trumpets”- Nathan Mayer Rothschild (1777-1836), 1810“Buy when there's blood in the streets,

even if the blood is your own.”

- Nathan Mayer Rothschild, 1st Baron Rothschild (1840-1915), 1873

Robert L. Rauch, Director of Research+1-203-552-1905rrauch@gramercy.comDavid Herzbergdherzberg@gramercy.comCarlos Gomez, CFAcgomez@gramercy.comLarry Gelge@gramercy.com

August 31, 2010

I. Overview

Distressed debt investing has been recognized as a distinct investment style for over the last two decades. Over thatperiod, returns have outperformed most traditional asset classes with lower volatility, with the HFR distressed indexproviding 12.7% annualized returns vs. 8.0% for the S&P 500. In this report we begin by outlining the returncharacteristics and styles of distressed investing. One of the questions that investors ask about distressed investingis whether they should view distressed investing as merely a cyclical / opportunistic allocation or if one can make aprofitable long term allocation to the asset class. There is no question that distressed investing follows the economicand credit cycles, with periods of extraordinary opportunities and returns. However, we make the case that, to besuccessful, one needs to have an ongoing allocation in order to be involved in the early stages of the opportunitiesthat arise. Because most classic distressed investing is inherently a secondary market strategy, there is a “J-curve”effect whereas the the critical mass of debt instruments is transferred from par buyers to distressed investors well-before the bottom of the market. Moreover, there are always idiosyncratic opportunities that arise at any stage of thecredit cycle. Finally, after reviewing the investment analytics applicable to distressed investing in developed andemerging markets, we provide an overview of the market elements we see that should give rise to an extremely largeopportunity set for profitable distressed investing over the next five years.

II. What is “Distressed Debt”?

The two lead quotes are often cited and ascribed to the Rothschilds, although there is no proof of them ever utteringsuch words. Nonetheless, the Rothschild dynasty was noted for its contrarian investing style and they are the mostfamous institutionalized distressed investors in early financial market history.Distressed investing, at its most basic level, is a form of deep value investing typically with an event-driven elementas well. Distressed investing can take many forms, although these days it is usually used in connection withdistressed debt. One of the more widely accepted definitions of “distressed debt” is generally attributed to MartinFridson, one of the deans of high-yield bond analysis. Mr. Fridson classified distressed debt as debt trading with ayield to maturity of greater than 1000 basis points more than the comparable underlying treasury security. Anothercommonly used criterion is debt that trades below 80 cents on the dollar. However, the distressed debt universeincludes many other types of securities with different market prices, including defaulted fixed income instruments,stressed performing bonds, below-par bank loans, “busted” convertibles, credit default swaps, NPL portfolios, andpost-restructuring equity, to name a few.Distressed investing, sometimes pejoratively referred to as “vulture investing,” began to be recognized as a distinctinvestment style in the late 1980s/early 1990s with the problems with the US thrift industry and the collapse of theburgeoning high yield debt market and Drexel Burnham Lambert in 1990, followed by the success of investors inthe mid-1990s involved with the Resolution Trust Corporation and other forms of distressed investing.

III. Long-Term Return Profiles from Distressed Debt Investing

Distressed investors can find value across the full credit cycle and their performance is mostly driven by both theoverall credit market and idiosyncratic credit events. Performance tends to be better during and after economicturnarounds when spreads tighten. This is when the profits from the successful restructuring can be reaped.Distressed hedge funds can make money in all stages of the market cycle, by shorting overvalued securities in frothymarkets and by moving to extremely high levels of cash in order to maintain the “dry powder” necessary to takeadvantage of when the market turns and opportunities arise.

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Exhibit 1: Performance Comparisons – Distressed Index vs. Traditional Indices (12/31/89 – 7/31/10)

0200400600800100012001400

1 9 8 9 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0

I n d e x V a l u e

HFR DistressedCS High-YieldS&P 500MSCI World StocksJPM Global Bonds

Total: 1072%Annual: 12.7%Total: 510%Annual: 9.2%Total: 384%Annual: 8.0%Total: 225%Annual: 5.9%Total: 328%Annual: 7.3%

Source: Gramercy, Bloomberg

Exhibits 1 and 2 shows the relative returns of distressed investing – as measured by HFR’s Distressed Debt HedgeFund index – against the Credit Suisse high yield bond index, the S&P 500, the MSCI global equity index, and JPMorgan’s global bond index for the 20+ years from December 31, 1989 through July 31, 2010. Distressedoutperformed all of these indices by two to four times, with an annualized return of 12.7% vs. 8.0% for the S&P500, with significantly lower volatility. Correlation of distressed debt with equity was fairly muted at 0.5, and non-correlated with the global bond index (see Exhibit 3).

Exhibit 2: Performance Metrics – Distressed Index vs. Traditional Indices (12/31/89 – 7/31/10)

HFRI Distressed Vs. Traditional Indices, 1/1/90 - 7/31/10

HFR Distressed CS High-Yield S&P 500 MSCI World Stocks JPM Global BondsTotal Return 1072.03% 510.26% 383.75% 225.03% 328.33%Annualized Return 12.70% 9.18% 7.96% 5.89% 7.32%Annualized Volatility 6.65% 8.63% 15.14% 15.81% 6.02%Sharpe Ratio 1.32 0.61 0.26 0.12 0.56Best Month 7.06% 10.08% 11.44% 11.90% 6.56%Worst Month (8.50%) (15.84%) (16.79%) (19.79%) (3.83%)

Source: Gramercy, Bloomberg

Exhibit 3: Correlation Statistics – Distressed Index vs. Traditional Indices (12/31/89 – 7/31/10)

Correlation of Distressed Index Vs. Traditional Indices, 1/1/90 to 7/31/10

HFR DistressedCS High-YieldS&P 500MSCI World StocksJPM Global BondsHFR Distressed

1.000

0.733 0.500 0.519 (0.037)

CS High-Yield

1.000

0.571 0.598 0.129

S&P 500

1.000

0.895 0.135

MSCI World Stocks

1.000

0.249

JPM Global Bonds

1.000

Source: Gramercy, Bloomberg

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In addition to having low correlation with traditional investments, distressed debt also outperformed invirtually all of the worst months for performance for both global equity and debt over that 20 year period, as shownin Exhibits 4 and 5.

Exhibit 4: Distressed Debt Performance During Ten Worst Months for World Stocks

(20%)(14%)(12%)(11%)(10%)(10%)(9%)(9%)(9%)(9%)1%(0%)(2%)(2%)(2%)(4%)(1%)(6%)(8%)(8%)

(25%)(20%)(15%)(10%)(5%)0%5%

Oct '08Aug '98Sept '08Sept '02Sept '90Feb '09Aug '90May '10Sept '01Jan '09

MSCI World StocksHFR Distressed Index

Source: Gramercy, Bloomberg

Exhibit 5: Distressed Debt Performance During Ten Worst Months for World Bonds

(3%)(3%)(3%)(2%)(3%)(3%)(4%)(3%)(3%)(4%)3%1%(8%)1%1%(0%)2%1%7%0%

(10%)(8%)(6%)(4%)(2%)0%2%4%6%8%

Mar '91Oct '92Aug '95Jan '97Feb '99Jul '03Apr '04Oct '08Jan '09Dec '09

JPM Global BondsHFR Distressed Index

Source: Gramercy, Bloomberg

IV. Distressed Debt Strategies

One of the most common strategies for distressed debt investing is buying securities at a distressed price to what theinvestor believes is the net present value of the recovery. Typically, investors focus on high yield bonds andleveraged loans (bank debt of non-investment grade companies), but investors also will consider structured creditproducts (such as mortgage backed securities and CDOs), trade claims, leases, receivables, vendor financing, andother debt-like instruments. Within this typical strategy, there are generally two types of institutional investing sub-strategies: passive and active.A

passive

strategy is more trading oriented and investment managers do not receive non-public information. Assuch, they are not engaged in the restructuring negotiations and are not locked from selling their securities. Thestrategy tends to focus on larger companies with liquid securities with a shorter time frame to exit. Passive managersview the asset class from a cyclical standpoint and typically invest opportunistically. Passive managers can alsomake money by shorting securities they believe will decline in price.The

active

approach is divided between non-control and control.

Active non-control

investors are often membersof a creditor committee but typically do not lead the restructuring. They will likely receive non-public information